Tactical Asset Allocation Part Two: Diversify Your Portfolio With This Momentum Strategy

Reda Farran

12 months ago8:45 mins

Tactical Asset Allocation Part Two: Diversify Your Portfolio With This Momentum Strategy

When it comes to allocating your investments, there are “tactical” ways to go about it – and some of these strategies have very impressive track records. In this special three-part series, you’ll learn three different tactical asset allocation strategies to inspire your investing and boost your portfolio. Here’s part two: Composite Dual Momentum (CDM).

What is tactical asset allocation?

Tactical asset allocation is a “dynamic” investment strategy – one where you’re actively adjusting your portfolio to take advantage of market trends, aiming to maximize returns while minimizing risks. The best part about tactical asset allocation: it’s relatively easy to implement using exchange-traded funds (ETFs).

What are the basic concepts behind the CDM strategy?

As you might have guessed from its name, CDM is a “momentum strategy”: you invest in asset classes that have recently performed well based on the tendency of them to continue to perform well in the near future. Momentum is a well-studied phenomenon within the academic community. One of the reasons it works is the fact that investors have deep behavioral biases – like herding and extrapolation.

An important concept behind CDM is “dual momentum”, which refers to two types of momentum: relative and absolute. Relative momentum measures how an asset has performed relative to other assets over a certain time period. Absolute momentum, on the other hand, measures whether an asset has actually risen in value over a certain period of time.

The CDM strategy selects the best performing asset classes (relative momentum) but only if their recent returns are positive (absolute momentum). If neither of these criteria are met with a particular asset, the strategy calls to shift the amount that would’ve been invested in that asset to cash.

Credit where credit is due: the CDM strategy comes from Gary Antonacci’s research paper, “Risk Premia Harvesting Through Dual Momentum”.

Which asset classes does the CDM strategy trade?

CDM divides a portfolio into four different groups, each targeting a different part of financial markets: equities, credit, real estate, and economic stress. In each group, the strategy selects one of two related asset classes, or cash. So in total, the strategy trades eight different ETFs.

The CDM strategy’s four portfolio groups and their associated asset classes
The CDM strategy’s four portfolio groups and their associated asset classes

How is the CDM strategy implemented?

The strategy trades and rebalances monthly. So on the last trading day of the month, you would do the following.

Step 1

Calculate the percentage price change of each of the eight ETFs over the past 12 months.

Step 2

For each of the four groups, find the ETF with the highest 12-month return (relative momentum). If that ETF’s return is positive (absolute momentum), invest 25% of the portfolio in it. If not, move that 25% of the portfolio to cash.

Step 3

Hold on to the ETFs until the last trading day of the following month. Then go back and repeat the steps above. Even if the ETFs you end up investing in don’t change, repeating the steps above ensures that you rebalance your portfolio to the strategy’s intended weights – that’s important.

How has the CDM strategy performed?

Performance tracker AllocateSmartly has compiled robust data on the CDM strategy’s historical performance, even projecting it back to 1973. While looking at this in isolation is all well and good, it’s more informative to compare performance to a benchmark – in this case, a basic 60/40 strategy that invests 60% in US stocks and 40% in US government bonds.

CDM vs. 60/40 performance (logarithmic scale). Source: AllocateSmartly.com
CDM vs. 60/40 performance (logarithmic scale). Source: AllocateSmartly.com

Measured over the past 50 years or so, the CDM strategy generated an impressive average annual return of 12% – more than two percentage points higher than the 60/40 benchmark’s 9.7%. What’s more, it managed this while taking on a lot less risk: the CDM strategy’s volatility was 8.2% over the same period – lower than the 60/40 portfolio’s 9.8%. Taken together, this means that the CDM strategy generated much higher investment returns per unit of risk.

Another important measure for assessing a strategy’s risk is maximum drawdown (MDD): the largest peak-to-trough decline in the value of a portfolio. The CDM strategy’s MDD over the past half-century was a relatively modest 11% – about one third of the 60/40 benchmark’s 30%.

What’s the opportunity here?

CDM has an impressive track record: it has generated excellent investment returns per unit of risk. And the strategy’s small 11% MDD suggests it has done a great job at minimizing large investment drawdowns. So if you apply this strategy to your investments, you may well boost your returns. Having said that, the old investment adage – “past performance is no guarantee of future results” – applies here: the CDM strategy may not necessarily perform well in the future and/or may experience a larger peak-to-trough loss of 11% at some point.

There’s a lot to like about the CDM strategy. On top of its strong risk-adjusted investment returns, the strategy has a relatively low turnover: it makes just ten trades a year, on average. I like how the strategy forces diversification by using four groups of asset classes, while capping the weight of each to 25%.

In part one, I discussed Defensive Asset Allocation. With that particular strategy, you could end up with investments in a bunch of similar asset classes – US equities, European equities, and Japanese equities, for example. But in the CDM strategy, if the entire portfolio is invested – that is, it’s not holding any cash – it would be evenly split among equities, corporate bonds, real estate, and gold or government bonds.

What are the risks involved?

CDM has two drawbacks. First, over the past 50 years or so, the portfolio averaged out to be 25% invested in cash. While the strategy does this for good reason – to avoid investing in falling asset classes – it can still be a drag on investment performance to hold a large chunk of cash generating no return.

Second, I don’t personally expect the strategy to continue averaging strong returns in the medium term. That’s simply down to the current environment: stock valuations are sky-high, bond yields are super low, and the real estate market is arguably in a bubble. So a portfolio evenly split among these asset classes might struggle a bit going forward.

Whether you decide to implement CDM or not, there’s a lot you can take away from the strategy and apply to your everyday investing. The concept of looking at both relative and absolute momentum is very sound, and one that you can apply to different assets – like choosing between different thematic ETFs, to name just one example.

That’s it for part two: CDM. Don’t miss part three of this series, where I’ll break down another high-performing tactical asset allocation strategy.

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